We have heard so many times how important it is to diversify your financial portfolio. And that’s actually true and very important. It is essential that you should diversify your financial portfolio, and not put all your eggs in one basket. A personal stock portfolio needs to be diversified so that you won’t have the risk of losing everything when one stock falls in which you have kept all your money.
However, there is also a thing called over diversification. That can be as disadvantageous as not diversifying a financial portfolio.
In this article, we are going to tell you how you can maintain the perfect balance when creating your financial portfolio.
What is Diversification?
When people talk about portfolio Diversification, they refer to investors trying to reduce market risk by investing in a number of different companies, sectors, industries, and even in a number of countries.
Most investment professionals will tell you that while diversification does not give any guarantees against financial loss, it is a useful strategy for attaining long-term financial goals. Many studies prove that financial diversification not just works, but is very beneficial. Since it spreads out your investments in areas with low correlation, your risk level is highly minimized.
This happens because industry sectors and entire industries don’t normally fluctuate in the market at the same time, or at least not at the same rate. If you mix your portfolio, you will experience less major drops in your investments. This is because while some sectors may be affected by the market, others won’t be. And thus, the rest of your investments shall be the same. Portfolio diversification gives you a more consistent financial portfolio performance.
That being said, you should remember that regardless of how much diversification you have, there will still be risks. A small market movement or a bad company performance may not harm your financial portfolio, but a global economic crisis can. You can reduce risks with individual stocks, also called unsystematic risk, but that brings inherent systematic risks which affect almost all stocks. Diversification can’t help you that much.
Portfolio diversification and pushing away unsystematic risk
Generally, the way to measure risk is to study volatility levels. This means the more sharply a stock’s performance fluctuates, the riskier it is. Standard deviation, which is a statistical concept, is used to measure volatility. You can think of standard deviation as risk.
Modern portfolio theory says you’ll get very close to achieving an ideal level of diversity after getting the 20th stock in your portfolio. It is found that with a portfolio of this number of stocks, the risk is reduced by as much as 22% to 27%. More stocks, from 20 to 1000 reduced risk by just 2.5%.
Many investors wrongly think that risk is directly proportional to the number of stocks in your portfolio. This is not true. It only works up to a certain point.
True portfolio diversification
The modern portfolio theory doesn’t suggest that you get 20 stocks to get optimum diversification. It is still important to diversify across companies, industries, industry sectors and even countries. It means you’ll be buying uncorrelated stocks. Portfolio diversification should also be across bonds, real estate, commodities, alternative assets, and others.
Portfolio diversification is good, but only till a certain point. It is commonly considered that a well-balanced portfolio is one with around 20 stocks, as it takes away the maximum risk. Getting more stocks won’t be benefiting you a lot.